Australian Federal Court Concludes Massive Internal Control Failures Aren’t Important to Reasonable Investors
Slogging through the Australia federal court’s recent 291-page decision in the securities class action against Commonwealth Bank of Australia (CBA),[1] I’m reminded of the adage about not seeing a forest for the trees. The decision parses the facts presented at trial with such granularity that readers lose sight of the bigger picture events.
Fortunately, the court also released a four-page summary. This ‘forest’ view of the decision should concern investors, particularly those focused on Environmental, Social and Governance (ESG) investing.
On Aug. 3, 2017, the Australian Transaction Reports and Analysis Centre (AUSTRAC) announced civil penalty proceedings against CBA for “serious and systemic non-compliance” with the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (AML/CTF Act).
CBA senior executives considered the massive control failures important, spending AU$400M on AML/CTF compliance. Australian regulators also considered the failures important, imposing a $700 million penalty.
Considering those failures from an investor’s perspective, however, the court reached the opposite conclusion. The presiding judge found senior management knew months or even years earlier about systemic non-compliance, associated risks, and the potential for sanctions. However, after 20 pages of parsing and deconstructing evidence, he determined that no reasonable investor would have cared and dismissed the case.
“I am not satisfied that the Information, in any of its pleaded forms, was information that, if disclosed at the relatively leaded times, would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of CBA shares,” the justice wrote in the decision. “More generally, I am not satisfied that the Information, in any of its pleaded forms, was information that a reasonable person would expect to have a material effect on the price or value of CBA shares if that information were to have been generally available at the relevantly pleaded times.”
Similarly, despite a statistically significant “abnormal return” or price drop of AU$3.29 per share following the regulator’s announcement, the judge concluded – after 25 pages of parsing and deconstructing evidence – that plaintiffs failed to prove loss causation and damages. Among other things, information in the regulator’s release did not match information the bank allegedly failed to disclose.
CBA also argued, and the judge accepted, that had the bank disclosed the problems itself, instead of the regulators, it could have accompanied the disclosure with ‘contextual’ information – such as the size of the bank’s operations – that would have reduced the significance of its failings in the eyes of investors.
What Does This Mean for Shareholders?
Besides its counterintuitive result, the decision has three “forest” level takeaways for investors:
Takeaway #1: ESG investors should view this decision as antithetical to their goals. These investors do consider well-functioning internal company controls important to their decisions to buy and hold shares. They try to direct capital towards companies with effective governance programs that comply with the law. If company management knows about massive failures in anti-bribery and anti-money laundering systems but isn’t required to disclose them under AU law, then the same holds true for control breakdowns in other areas potentially harmful to society and shareholder value.
Takeaway #2: This decision may embolden Australian defendants to fight securities class actions harder and longer, and to take more to trial. This could potentially result in higher prosecution costs and fewer cases filed in the future.
Takeaway #3: Companies have more incentive to avoid or delay the disclosure of known problems given the increased likelihood of evading liability. The CBA decision offers them a good roadmap. Best practices going forward will include generalized statements about internal controls and their reliability, which are less actionable than specific ones. They will also include obfuscation in disclosures regarding failures, since granular analysis suggests there will be no causation or harm if those disclosures don’t match information allegedly known internally.
Furthermore, companies will be able to defend proceedings by arguing that the information they allegedly ought to have disclosed differs from the precise terms of an announcement as they themselves would have drafted it – including any contextual information they say would have been released to ‘soften the blow’. In other words, defendants skate actual harm to shareholder value by hypothesizing about what they might have said and how it might have impacted share prices.
In sum, the CBA decision is sobering for investors. It portends fewer securities class actions, with fewer, later, and smaller resolutions. In the wake of similar scandals, investors will need to rely more heavily on capital re-allocation to sanction poor governance. On the plus side, it suggests candy bars aren’t fattening if you take small enough bites.
[1] Zonia Holdings Pty Ltd v Commonwealth Bank of Australia Limited (No 5), [2024] FCA 477 (May 10, 2024).
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